Rescuing the financial sector

As I highlighted in my last piece, by 2007, the financials of the Indian banking system were robust again. The industry had a return on assets (RoA) of over 1 per cent, gross and net NPAs below 2 and 1 per cent, and a cost income ratio below 45 per cent. Good health prompted the government to re-enact the familiar cycle of pillage. This time to build infrastructure. The new instrument was public private partnerships (PPPs) where the private sector was to build 40 per cent of the $ 500 billion infrastructure target of the Eleventh Plan using PSB balance sheets. During the plan period, 4,910 capital projects of over Rs 150 crore were started but unfortunately 2,238 of them were stalled for over two years due to disputes in PPP contract terms or denial of government clearances on environment or land. Two-year delays obviously fully eroded the private equity in the capital projects. The debt-equity ratios of infrastructure companies rose from 1.3 in 2008 to 3 in 2013. Fifty per cent of bank restructured assets were in infrastructure, steel, power and telecom sectors. By 2013 the banking system was back in turmoil.  

2013-18 failed clean-up phase: The third phase of Indian banking began with a new governor. In view of the build of bad loans the Reserve Bank of India took a series of aggressive supervisory actions to clean up bank balance sheets to resounding media applause. These aggressive actions neither understood the genesis of the current crisis or the role PSBs had played in funding the government and in effect in keeping Indian democracy afloat as described in my last article. Further supervisory actions were taken, with Brahmanic disdain, to punish the crooked Indian capitalist. Supervisory actions were not supported by monetary policy and inflation had become the singular target of RBI policy.  

Seven RBI actions accentuated the banking rot: 

  • RBI created a monetary policy committee and set an arbitrary 4 per cent inflation target for India to be managed within a 2 per cent band. Deviations outside the band were to be reported to Indian Parliament. 
  • The RBI consistently overestimated inflation and maintained interest rates at the highest levels in the world. It missed the opportunity of using treasury profits for clean-up.   
  • An asset quality review (AQR) with tighter recognition norms was started in 2015 to clean up the supposed rot in PSBs, triggering major bank quarterly losses.
  • The easy NBFC licensing regime was continued, but only two new bank licences were issued to IDFC and Bandhan Bank, out of many strong bank license applicants. 
  • New type of bank licenses — payments and small finance banks — were introduced without testing the viability of the new models. 
Regulatory guidelines: Ambiguity in capital norms, holding company structures, and bank ownership norms remained. The old “Washington Consensus” dogmas around diversified shareholdings in banks (despite the lessons of global financial crisis) and a prohibition of industrial houses from owning banks continued, leading to a situation where all new private banks in India today have majority foreign ownership. 

The welcome Insolvency and Bankruptcy Code was introduced in this period strengthening creditor rights in India. 

By keeping interest rates high with the accompanying strong rupee, the RBI induced a slowdown in capital investments and hurt exports; it also prevented banks to use treasury profits to recapitalise. The fast clean up attempted led to a sharp contraction in credit, tightened liquidity for MSMEs and pushed many into bankruptcy.  Marginal accounts turned bad leading to capital scarcity and virtually brought bank lending to a standstill.  Lending shifted to wholesale funds-dependent NBFCs, increasing risk in the system. Arbitrary low inflation targets, 3 per cent below a 50-year 7 per cent trend line, benefitted only short-term global capital making India the haven for the “carry trade”. RBI monetary actions that precipitated the banking crisis were accompanied by rank bad supervision missing the failures — for example, of ILFS, DHFL and now PMC Bank. History will judge the RBI very poorly during this period. 

Six urgent actions are needed to rescue the financial sector today:
  • I am not an advocate of simplistic privatisation in India. I believe the State Bank of India should stay government majority-owned and other PSBs should have government as their single largest owner but with a stake below 50 closer to 26 per cent. This is a powerful, overdue, recommendation. It provides these banks the decision-making autonomy required to survive. It removes needless interference and the paralysing fear of vigilance and provides HR freedom to recruit, retain and develop talent. This one act will likely double the price to book of PSBs.
  • Large NBFCs should be forcibly converted or acquired by banks to mitigate systemic risk. Payment and SFBs should be given full bank licenses and stopped henceforth. However, an easy NBFC licensing regime should continue to spur financial innovation. 
  • The dual control of cooperative banks and unnecessary tax benefits available to them should be abolished. Similarly old private sector banks should be asked to transform or be acquired by large NBFCs or larger banks.  
  • A clean-up of the regulatory structure in terms of guidelines — holding company structures, promoter holding limits, ownership of banks by industrial houses subject to inter group lending guidelines, supervisory oversight of NBFCs — is overdue.
  • The Bank Bureau Board is not needed and there is a need to improve the quality of talent in both the DFS and RBI.  
  • Parliament should be apprised on the state of banking — covering, for example, the inexcusable unfilled positions of MD in BoB and BoI. 
The new RBI governor should support these actions. There is no excuse for India’s banking sector to be moribund. We have the best technology stack and financial services talent globally. Our journey to a $5 trillion economy requires budding entrepreneurs to access credit by banks using technology and data. A government with the courage to abrogate Article 370 must not shy away from the banking reform required. India just cannot wait.  
(Series concluded)
The author is chairman, BCG India | Views are personal

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